History will define 2008 as the year of the government's Wall Street bailout. But separate and apart from government intervention on residential loans, there will also be non-government intervention in the sale of loans – including loans secured by commercial real estate.
Most loan sales will be related to distressed loans, distressed property or distressed lenders that need to move loans off their books. Sellers will range from banks and other financial institutions to sophisticated real estate bargain hunters, and buyers will range from private money lending funds to private parties. Although recent years have seen few loan sale centers, expect more of these centers to emerge.
Sellers and buyers of loans have one common desire: to close the deal. But first, let us look at what motivates each party in order to better understand the legal needs of each.
Sellers are generally motivated by factors such as generating cash and freeing themselves of loans that may be nonperforming, as well as avoiding having to foreclose and then manage real estate owned assets. In short, selling is an exit strategy.
Buyers are motivated by several factors, ranging from generating sources of income (although most loans in this economic cycle will be nonperforming and therefore – unless restructured by the buyer – will not generate income) to being a Good Samaritan. A Good Samaritan, in this case, is typically a relative or friend of a borrower, or guarantor who wants to take pre-foreclosure control of a loan from an institution to protect a borrower or guarantor who has faced hard times.
Pre-foreclosure control of a loan gives the buyer limitless opportunities, including entering forbearance agreements, deeds in lieu of foreclosure, and restructuring a loan in a manner that returns profit to the buyer by any number of other scenarios.
Loans may be sold as part of entire portfolio sales or via individual note sales. In this economic cycle, we are likely to see both methods. Whether one is purchasing a portfolio or an individual note, there are basic fundamentals to be reviewed from a purchasing-strategy perspective, a due diligence perspective and a legal perspective.
Except for the Good Samaritan, most buyers of a single loan or loan portfolio will be buying a loan as part of a plan to buy property. Target loan acquisitions are, therefore, sometimes found by identifying properties in foreclosure.
Properties in foreclosure are generally found in public records, but they are more easily identified by talking to real estate brokers, bankers and others in the area where the real estate is located. For buyers who are less interested in foreclosures and who may want performing loans, one must simply mine the lending community to find lenders that have loans they desire to sell.
In any case, networking among bankers and brokers, as well as loan recovery professionals, including lawyers and receivers, is recommended.
Strategies may also vary based upon whether a note buyer is looking to foreclose and simply sell to a bidder at sale; foreclose, expecting no bidder at sale, and then do what is necessary to enhance the property for resale; or foreclose, expecting no bidder at sale, and then hold the property for investment.
Every loan purchase includes an element of risk, and purchasers of loans need to understand what they are purchasing. Except in the instance of a large portfolio, it is best to understand the loan, the real estate securing the loan and the borrower (and guarantor). The savvy purchaser of a loan approaches the transaction as if it is making the loan.
Purchasers may have different motives for purchasing loans based upon whether a distressed loan is the result of a weak borrower and guarantor or the result of changes in the value of the property.
The value of the property needs to be understood, as post-loan acquisition strategies may meet varying degrees of success depending on whether the decline in value is the result of the changing character of a neighborhood, the condition of property or tenant vacancies.
In all events, the purchase price of the loan needs to be premised, in part, on the buyer's ability to turn around the property. Not all loans are for all buyers, as some may not have the ability or staying power to turn around a particular property post-foreclosure.
Each property that secures a loan has different issues. In addition to the foregoing, there may be threatened or pending litigation over easements or other issues, environmental issues, or other health and safety property condition issues that are beyond the scope of deferred maintenance, or management issues.
In addition to underwriting the borrower, guarantor and property, a loan purchaser will also want to review the loan documents and title reports. Loan documents should be reviewed with a focus on both the validity and enforceability of loan documents, as well as particular provisions that may affect post-loan acquisitions, such as remedies upon default (e.g., Can a receiver be appointed?).
Assistance of counsel in loan document review is recommended. The title should be reviewed to assure the priority of the deed of trust or mortgage securing the loan. If there are senior loans identified, a purchaser will need to do further due diligence to identify whether or not the senior loan is performing, and if it is not, what the status is of the loan in foreclosure.
The status of a senior loan may well affect the economics of the loan purchase. Unpaid taxes or other liabilities may be found and may affect how one underwrites a loan purchase.
It is important to understand the likelihood of a borrower's filing bankruptcy if the loan is in default at the time of purchase. Bankruptcy means one will likely have to file a motion for relief of stay in bankruptcy. If that is the case, it is again recommended that the buyer consult with legal counsel to determine the cost of bankruptcy litigation, likelihood of success in bankruptcy litigation and the duration of time it will take to achieve success.
Additionally, in most instances, success will only be defined as relief from the automatic stay to allow one to foreclose.
Essential loan documents
Other pre-foreclosure litigation scenarios should also be considered, including buyer-initiated litigation to have a receiver put in place, or even borrower-initiated litigation, as a borrower may raise any number of causes of actions or defenses against loan enforcement.
Purchasers of large loan portfolios may preclude extensive due diligence. To the extent possible, there should still be review of all loan documents prior to a portfolio purchase, review of the selling lender's underwriting and loan servicing policies, review of loan payment histories and review of lender loan title insurance policies. Loan purchasers will also want to review the loan files of all loans being purchased.
The legal fundamentals of both loan portfolio sales and individual note sales are the same from the standpoint of core documentation. These sales will be documented by the following documents:
- loan purchase agreement,
- assignment of deed of trust, and
- assignment and transfer of loan documents.
The allonge is a document that effectively transfers the promissory note. The assignment of deed of trust is a document that, when recorded in the county in which the original deed of trust or mortgage was recorded, assures the buyer of the loan is the sole beneficiary.
The assignment of loan documents transfers ownership in the other loan documents (e.g., guaranties) that were executed by the borrower and the lender in connection with the making of the loan.
The loan purchase agreement is a document that buyers will want to negotiate and sellers will seek to resist. From the seller's standpoint, it should be a noncontroversial document that describes the background of the loan in adequate detail, including all original loan documents and any modifications; sets forth the outstanding amount of the loan and whether or not it is in default; states that the sale of the note is without recourse (which should also be stated on the allonge); and provides descriptions of the conditions of closing on the closing date, which may be limited to transfer of loan sale documents upon receipt of funds and the buyer's obtaining an ALTA 104 endorsement to the lender's title policy.
The ALTA 104 endorsement will guarantee that upon the recording of the assignment of mortgage, the buyer will have the same rights and coverage of the seller as of the date of issuance of the lender's title policy.
Buyers will want all of the above terms – and more. Buyers generally want representations, many of which sellers will refuse – or at least be reluctant – to give. As for sellers, the note sale should be ‘as is,’ without any representations other than that it owns the loan and has the authority and power to sell it.
Because buyers want to avoid problems, they will seek to put the burden on the seller to represent and warrant matters, which include ensuring the following:
- The seller – if an institution – has complied with all laws, statutes and regulations relating to the loan;
- The seller has undertaken no act that would give rise to lender liability;
- There are no matters not of record affecting the property that secures the loan that the seller has not disclosed;
- The borrower has no right of offset, counter-claim or defense to the enforcement of the loan;
- The loan is enforceable in accordance with the terms of the loan documents;
- The title policy for the loan is a good policy;
- The loan files, if being transferred, are the complete files relating to the loan;
- There are no loan documents or modifications to the loan except as disclosed by the agreement; and
- There is no litigation pending or threatened by the borrower against the lender for any matter that would affect the loan.
When buying a loan, borrowers may wish to obtain a borrower estoppel (and guarantor estoppel if there is a guarantor on the loan), especially in those instances in which it knows the person or party who is the borrower or guarantor on the loan, and the purchase is part of a preconceived coordinated strategy by the borrower or guarantor on the one hand, and the buyer on the other hand (including the Good Samaritan purchase).
The borrower estoppel and guarantor estoppel should require the borrower and guarantor to acknowledge that the buyer is purchasing the note in material reliance upon the estoppel and that the borrower (and guarantor, if applicable) certifies to specific matters.
These matters may include – but not are limited to – the amount of the loan; that there have been no actions by the lender that affect the enforceability of the loan; that the borrower has no right of offset, counter-claim or defense to the enforcement of the loan; that the borrower has no claim of any kind against the lender/seller that it will assert in any lawsuit; and that the borrower is solvent and has no intention of filing bankruptcy.
If there has been a coordinated workout plan discussed by the buyer, borrower and guarantor, prior to the note sale's being consummated, the buyer may negotiate releases. However, one must be careful to state consideration for the releases (e.g., forbearance for a period of time), and/or that upon the closing, the borrower and guarantor will execute a formal workout agreement that may be attached as an exhibit to the estoppel.
Basic note-sale strategies are important, and each note sale or loan-portfolio sale should include documentation that addresses what may be unique issues to the sale.
Gordon L. Gerson is a principal of Gerson Law Firm APC in San Diego. He represents lenders throughout the U.S. in loan originations and loan servicing matters, including loans secured by commercial, industrial, multifamily, lodging and other character property. Gerson can be reached at (858) 452-5400 or firstname.lastname@example.org.